ITAD Ruling No. 046-01

May 11, 2001 ITAD RULING NO. 046-01 Articles 13 & 23, RP-US Tax Treaty Articles 12 & 13, RP-Denmark Tax Treaty BIR Ruling No. ITAD-123-00 Punongbayan & Araullo Ernst & Young International 20th Floor, Tower I 6766 Ayala Avenue 1200 Makati City Attention: Vic C . Mamalateo Tax Partner Gentlemen : This refers to your application for relief from double taxation dated January 19, 2000, on behalf of your client, UNISYS AUSTRALIA LIMITED Philippine Branch (UAL-PB), requesting for confirmation of your opinion that the payments to be made by the latter to UNISYS CORPORATION (UNISYS) are considered royalties and, thus, subject to the preferential tax rate of 15%, pursuant to the "most-favored-nation" clause [Article 13(2)(b)(iii)] of the RP-US Tax Treaty in relation to Article 12(2) of the RP-Denmark Tax Treaty. It is represented that UAL-PB is a branch of Unisys Australia Limited, a corporation organized and existing under the laws of Michigan, U.S.A., duly registered with the Philippine Securities and Exchange Commission; that it is doing business in the Philippines under the business style "Unisys Philippines"; that it is primarily engaged in the business of designing, manufacturing and marketing components, products, systems and forms and supplies for the recording, storing, handling, computing, processing and communicating of information and data, and of providing related services; that UNISYS is a corporation organized and existing under the laws of the State of Delaware, USA, with no permanent establishment in the Philippines, as per certification dated July 6, 2000 issued by the Securities and Exchange Commission; that it is likewise engaged in the business of designing, manufacturing and marketing components, products, systems and forms and supplies for the recording, storing, handling, computing, processing and communicating of information and data, and of providing related services; that in 1998, UAL-PB entered into an Intellectual Property License Agreement with UNISYS, effective October 1, 1998, for a period of two (2) years, subject to automatic and successive renewal for additional periods of one year, unless a notice of termination is given by either party; that the said Agreement complies with the provisions of the Intellectual Property Code on Voluntary Licensing as per Certificate of Compliance No. 5-1998-00089 dated January 4, 1999 issued by the Intellectual Property Office of the Department of Trade and Industry; that said Agreement grants UAL-PB a non-exclusive license to reproduce, translate, distribute and prepare derivative works of, and use in its business such present and future rights in patents, copyrights, trademarks, trade secrets, software, documentation, know-how, maintenance and products support materials and professional service support materials under patent, copyright and mask work, trade secret and trademark law in the Philippines; that in consideration for the said grant, UAL-PB pays UNISYS royalties, to wit: (1) an amount equal to fifty percent (50%) of UAL-PB's Software Revenue, (2) an amount equal to ten percent (10%) of UAL-PB's Maintenance Revenue, (3) an amount equal to five percent (5%) of UAL-PB's Professional Services Revenue, and (4) an amount equal to either, at UAL-PB's option, (a) three percent (3%) of revenues from UAL-PB's OEM Products or (b) four and four-fifths percent (4.8%) of UAL-PB's OEM Product Costs. In reply, please be informed that Article 13 of the RP-US Tax Treaty provides as follows, viz : " Article 13 " ROYALTIES "1. Royalties derived by a resident of one of the Contracting States from sources within the other Contracting State may be taxed by both Contracting States. "2. However, the tax imposed by that other Contracting State shall not exceed a) In the case of the United States, 15 percent of the gross amount of the royalties, and b) In the case of the Philippines, the least of: (i) 25 percent of the gross amount of the royalties, (ii) 15 percent of the gross amount of the royalties, where the royalties are paid by a corporation registered with the Philippine Board of Investments and engaged in preferred areas of activities, and (iii) the lowest rate of Philippine tax that may be imposed on royalties of the same kind paid under similar circumstances to a resident of a third State. EHCaDS "3. The term "royalties" as used in this Article means payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work, including cinematographic films or films or tapes used for radio or television broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or other like right or property, or for information concerning industrial, commercial or scientific experience. The term "royalties" also includes gains derived from the sale, exchange or other disposition of any such right or property which are contingent on the productivity, use, or disposition thereof. xxx xxx xxx The Tax Treaty defines "royalties" to include "payments of any kind received as a consideration for information concerning industrial, commercial or scientific experience." According to the Commentaries of the ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT (OECD) Committee on Fiscal Affairs on the Model Tax Convention [par. 11, Commentary on Article 12 (Royalties), 1998, p. 151], such information alludes to the concept of "know-how" . The definition of know-how, which has been adopted by the said Committee, is "all the undivulged technical information, whether capable of being patented or not, that is necessary for the industrial reproduction of a product or process, directly and under the same conditions; inasmuch as it is derived from experience, know-how represents what a manufacturer cannot know from mere examination of the product and mere knowledge of the progress of technique.'' In the know-how contract, one of the parties agrees to impart to the other, so that he can use them for his own account, his special knowledge and experience which remain unrevealed to the public. As thus defined by the Intellectual Property License Agreement by and between UAL-PB and UNISYS, the information to be imparted by UNISYS falls under the purview of know-how. Hence, payments received by UNISYS in consideration for the said grant are deemed royalties. The RP-US Tax Treaty also speaks of the " lowest rate of Philippine tax that may be imposed on royalties of the same kind paid under similar circumstances to a resident of a third State ." This is known as the most-favored-nation clause of the RP-US Tax Treaty. The purpose of a most favored nation clause is to grant to the Contracting State treatment no less favorable than that which has been or may be granted to the "most favored" among other countries. Pursuant therefore to the most favored nation clause of the RP-US Tax Treaty, it is your stand that the phrase "paid under similar circumstances" is to be interpreted, according to some Court of Tax Appeals decisions, to refer to the royalties paid and not to the payment of taxes since what is paid to a resident of a third State is royalty and not the tax, and that the provisions of Article 12 of the RP-Denmark Tax Treaty, particularly the preferential tax rate of 15%, may be made to apply in the case of UNISYS. Said Article 12 reads: "Article 12 "Royalties "1. Royalties arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State. "2. However, the royalties may also be taxed in the Contracting State in which they arise and according to the laws of that State, but if the recipient is the beneficial owner of the royalties the tax so charged shall not exceed 15 per cent of the gross amount of the royalties. "The competent authorities of the Contracting States may by mutual agreement settle the mode of application of this limitation. "xxx xxx xxx" In the case of Commissioner of Internal Revenue vs. S.C. Johnson and Son, Inc. and Court of Appeals (G.R. No. 127105, June 25, 1999), the interpretation of the Court of Tax Appeals of the phrase "paid under similar circumstances" was not sustained, thus: "We are unable to sustain the position of the Court of Tax Appeals, which was upheld by the Court of Appeals, that the phrase 'paid under similar circumstances' in Article 13 (2) (b) (iii) of the R P-US Ta x Treaty should be interpreted to refer to payment of royalty, and not to the payment of the tax, for the reason that the phrase, 'paid under similar circumstances' is followed by the phrase 'to a resident of a third state.' The respondent court held that "Words are to be understood in the context in which they are used', and since what is paid to a resident of a third state is not a tax but a royalty 'logic instructs' that the treaty provision in question should refer to royalties of the same kind paid under similar circumstances. "The above construction is based principally on syntax or sentence structure but fails to take into account the purpose animating the treaty provisions in point. To begin with, we are not aware of any law or rule pertinent to the payment of royalties, and none has been brought to our attention, which provides for the payment of royalties under dissimilar circumstances. The tax rates on royalties and the circumstances of payment thereof are the same for all the recipients of such royalties and there is no disparity based on nationality in the circumstances of such payment. On the other hand, a cursory reading of the various tax treaties will show that there is no similarity in the provisions on relief from or avoidance of double taxation as this is a matter of negotiation between the contracting parties. "xxx xxx xxx "The reason for construing the phrase 'paid under similar circumstances' as used in Article 13 (2) (b) (iii) of the R P-US Ta x Treaty as referring to taxes is anchored upon a logical reading of the text in the light of the fundamental purpose of such treaty which is to grant an incentive to the foreign investor by lowering the tax and at the same time crediting against the domestic tax abroad a figure higher than what was collected in the Philippines." Article 23 of RP-US Tax Treaty reads: "Article 23 "RELIEF FROM DOUBLE TAXATION "Double taxation of income shall be avoided in the following manner: "1. In accordance with the provisions and subject to the limitations of the United States (as it may be amended from time to time without changing the general principle hereof), the United States shall allow to a citizen or resident of the United States as a credit against the United States tax the appropriate amount of taxes paid or accrued to the Philippines and, in the case of a United States corporation owning at least 10 percent of the voting stock of a Philippine corporation from which it receives dividends in any taxable year, shall allow credit for the appropriate amount of taxes paid or accrued to the Philippines by the Philippine corporation paying such dividends with respect to the profits out of which such dividends are paid. Such appropriate amount shall be based upon the amount of tax paid or accrued to the Philippines, but the credit shall not exceed the limitations (for the purpose of limiting the credit to the United States tax on income from sources within the Philippines or on income from sources outside the United States) provided by United States law for the taxable year. . . ." On the other hand, Article 23 of the RP-Denmark Tax Treaty provides, viz : "Article 23 "ELIMINATION OF DOUBLE TAXATION "xxx xxx xxx "2. In Denmark, in accordance with the provisions and subject to the limitations of the laws of Denmark, as may be amended from time to time without changing the general principle hereof, double taxation shall be eliminated as follows: a) Subject to the provisions of sub-paragraph (c), where a resident of Denmark derives income which, in accordance with the provisions of this Convention, may be taxed in the Philippines, Denmark shall allow as a deduction from the tax on the income of that resident, an amount equal to the income tax paid in the Philippines; b) such deduction shall not, however, exceed that part of the income tax, as computed before the deduction is given, which is attributable to the income which may be taxed in the Philippines; c) where a resident of Denmark derives income which, in accordance with the provisions of this Convention shall be taxable only in the Philippines, Denmark may include this income in the tax base, but shall allow as a deduction from the income tax that part of the income tax, which is attributable to the income derived from the Philippines; "xxx xxx xxx." A cursory reading of the above-quoted Article 23 of the RP-US Tax Treaty and Article 23 of the RP-Denmark Tax Treaty, though differently worded, will reveal that they grant the same relief from double taxation to their respective residents who are covered thereby. Thus, the tax on royalties by Danish residents and US residents are paid under similar circumstances. US residents may, therefore, invoke the preferential tax rate of 15% under the RP-Denmark Tax Treaty Pursuant to the most favored nation clause of the RP-US Tax Treaty. Such being the case, this Office confirms your opinion that the payments to be made by UAL-PB to UNISYS as stipulated in their Intellectual Property License Agreement are deemed royalties and, thus, subject to the preferential rate of 15%, pursuant to the most favored nation clause [Article 13 (2) (b) (iii)] of the RP-US Tax Treaty in relation to Article 12 (2) of the RP-Denmark Tax Treaty. (BIR Ruling No. ITAD 123-00 September 1, 2000) Furthermore, under Section 108 of the said Code, the royalty payments to be remitted by UAL-PB is subject to the 10% value-added tax. Section 4.102-1 (b) of Revenue Regulations No. 7-95 provides that: "The VAT on rental and/or royalties payable to non-resident foreign corporations or owners for the sale of services and use or lease of properties in the Philippines shall be based on the contract price agreed upon by the licensor and the licensee. The licensee shall be responsible for the payment of VAT on such rentals and/or royalties in behalf of the non-resident foreign corporation or owner by filing a separate VAT declaration/return (BIR Form No 1600 Monthly Remittance Return of Value-Added Tax and Other Percentage Taxes Withheld) for this purpose . The duly validated VAT declaration/return is sufficient evidence in claiming input tax credit by the licensee ." In view of all the foregoing, UAL-PB shall be responsible for the withholding of income tax at the rate of 15% of the gross amount of royalties and the value-added tax at the rate of 10% of the contract amount. This ruling is issued based on the foregoing facts as represented. If upon investigation, it will be disclosed that the said facts are different, then this ruling shall be considered null and void. Very truly yours, Commissioner of Internal Revenue By: (SGD.) EDMUNDO P. GUEVARA Deputy Commissioner Legal and Inspection Group